The Meridian is the official blog of Scott Dauenhauer and Meridian Wealth Management. This blog will update you on financial planning and investment management topics. It will also explore the impact of world events on your portfolio.

Tuesday, October 26, 2010

Everyone asks about gold. This is the irony: just as Jim Grant tells us (correctly) that we all have faith-based paper currencies backed by nothing, it is equally fair to say that gold is a faith-based metal. It pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry. I would say that anything of which 75% sits idly and expensively in bank vaults is, as a measure of value, only one step up from the Polynesian islands that attached value to certain well-known large rocks that were traded. But only one step up. I own some personally, but really more for amusement and speculation than for serious investing. It may well work and it may not. In the longer run, I believe that resources in the ground, forestry, agriculture, common stocks, and even real estate are more certain to resist any inflation or paper currency crisis than is gold.

Monday, October 25, 2010

In a mind-boggling appearance today Sheila Bair attempted to sweep the current foreclosure fiasco under the rug by backing a plan to allow a "safe harbor" for certain loans currently in foreclosure. In other words the banks would be allowed to foreclose if certain conditions are met....NOT if the bank has proven that they have the right to foreclose. The rule-of-law when it comes to foreclosures is being crushed and now the FDIC is all in with their buds over at Fannie and Freddie leading the charge.

Regardless of if a homeowner is able to pay or can afford to pay we have a system of laws that must be followed. We can't start making exceptions for large banks/services out of convenience, especially after the abuse that has been heaped upon this nation by the very same banks.

Bair's comments received almost no immediate press - which is remarkable.

“On the interplay between the FED and STOCKS: Since Sept 1 – when QE was becoming a mainstream focus – if you only owned S&P on days when the Fed conducted Open Market Operations (in US Treasuries), your cumulative return is over 11%. in addition, 6 of the 7 times when S&P rallied 1% or more, OMO was conducted that day. this compares to a YTD return of 5.8%. the point: you would have outperformed the market 2x by being long on just the 16 days when – this is the important part – you knew in advance that OMO was to be conducted. The market’s performance on the 19 non-OMO days: +70bps.”

Prag Cap:

The Fed certainly doesn’t help their credibility when this sort of stuff is being thrown in people’s faces. It’s one thing to imply that you’re going to print millions of dollars. It’s a whole other thing to admit that you want to run a ponzi economy (as Brian Sack directly did). Amazing way to run an economy….

Friday, October 22, 2010

Tuesday, October 19, 2010

Unfortunately, the likely economic impact of this rapid depreciation is not benign. The Fed might like to believe that a cheaper dollar will improve trade by increasing U.S. exports and reducing imports. However, over the past two decades, and particularly in recent years, U.S. imports have been much more elastic in response to fluctuations in the U.S. dollar than exports have been. This suggests that provoking further dollar depreciation is likely to have negative effects on the global economy, owing to a shift away from imports, but with few positive effects for U.S. economic activity. Indeed, a further depreciation would unnecessarily create a negative wealth effect for U.S. consumers facing higher prices for imported goods and services. Any improvement in the trade deficit would be largely offset by downward pressure on U.S. consumption.

As a side note, some observers have suggested that QE represents nothing more than "printing money." While this might be accurate if the Fed never reverses the transactions, the most useful way to think about QE, in my view, is as an attempt to directly lower interest rates by purchasing Treasury securities. This interest rate effect - not any major inflationary outcome - is the cause of the dollar depreciation we are observing here. There is little doubt that the effect of large continuing fiscal deficits is long-run inflationary, but as I've noted repeatedly over the years, there is little correlation between inflation and temporary - even large - variations in the monetary base. Inflation is ultimately a fiscal phenomenon born of unproductive spending, regardless of how that spending is financed.

Monday, October 18, 2010

The economy is not improving. While the NBER may have called the recession over as of last June - the one in five people who would like to have a job would beg to differ (data from Shadow Stats). I’ve stated on my blog and to many of you that I don’t believe we will have a Double-Dip Recession because we never recovered from the first one. The U.S. is stuck in the D gear - depression. Enter the Federal Reserve.

Last year the Federal Reserve embarked upon a program where it printed nearly $2 Trillion to buy Fannie/Freddie Mortgages and U.S. Treasuries. Combined with changes to accounting rules the market and numerous risk assets shot up, in some cases doubling. Since the money printing stopped earlier in the year stock returns haven’t even been up by 1%. In August the Federal Reserve decided to “keep the motor running” or “warm up the car” so to speak by reinvesting interest and mortgage pre-pays into longer-term U.S. Treasuries - effectively keeping the money supply constant (perhaps I should say the Reserves constant). All of this in a prelude to the next big event which many believe will happen at the November FOMC meeting, but could be pushed to the December meeting - Quantitative Easing 2.0. This simply means more money printing to buy Treasury bonds and potentially mortgages.

The belief that more money printing is on the way and that it is a solution to our economic woes has been witnessed on Wall Street. Stocks had their best September in 77 years and there are now economic commentators who believe you cannot lose in stocks - regardless of what the economy does. In fact, it has gotten so bad that now the Street is collectively hoping economic data is bad so that the Federal Reserve will follow through with its plan to print more money. In short, economic improvement is good for stocks - economic depression is even better for stocks. Anybody see anything wrong with this thought process? Less you think the Federal Reserve is the only Central Bank doing this, be forewarned that the Bank of Japan is now printing money to buy Exchange Traded Funds and Real Estate...is the U.S. next?

Stock prices are driven by short-term forces, but over the longer-term they are driven by valuations and stocks are not priced for superior or even average returns going forward. If the economy was devolving and stocks traded for 10 times earnings - I could be excited about the prospects for stocks, even if I wasn’t hopeful about the economy. At 20 times earnings stocks are priced for perfection, if anything goes wrong they will suffer.

The question is no longer whether we should print more money, but how much more should we print? We will likely find out soon, but it is now clear that low interest rates are here to stay - for a long time. The goal of the Fed is to get you to stop saving your money in banks, money markets and short-term instruments that yield next to nothing and instead use that money to speculate on more risky assets such as stocks, long-term bonds and anything that will get asset prices up. The goal is to boost asset prices so they can be sold off bank and other balance sheets - to some greater fool...guess who that fool is?

There is an old phrase - “Don’t fight the Fed” and it appears Wall Street is following it. But should you? The answer is no - you shouldn’t follow the adage - you SHOULD fight the Fed. You cannot print your way to prosperity. If you could, why would anybody produce anything? Why is there still hunger in the world if the solution is simply to fire up the printing press?

I don’t pretend to know the short-term implications of Federal Reserve short-term thinking, but my belief is that we are on the wrong path. The Federal Reserve, led by Ben Bernanke is leading us toward a cliff and instead of building a bridge most of the pundits have decided to strap on bunging gear and pray that the cord is connected...to something. If the term Lemmings comes to mind it is only because it is appropriate.

Investing in this environment will not be easy and returns will likely not be great (though I do not discount a stock boom, but believe if it happens it will bust). My strategy is to create as much flexibility as possible and take risks where appropriate. My advice to those saving for retirement is to continue saving as much as you can, for those in retirement it is to preserve your assets as much as possible.

While my quarterlies don’t appear to be getting any less gloomy, you might be surprised to hear that I am quite an optimist long-term. I believe the world is on the verge of scientific discovery that will literally make the past one-hundred years look like the stone ages. It will take some time, perhaps decades - but the advancements in bio-tech, medicine, technology, energy and education will be leaps - not steps. The one constant will be change (usually that phrase annoys me, but I believe it will be true). The changes that will take place likely won’t be easy and the immediate impact of such changes can’t be accurately gauged. If you think the iPad is cool (and I do) you haven’t seen anything yet - one day the iPad will be akin to an 8-track player. The problem we have now is that there are too many structural issues standing in the way of the global economy and these have to be worked out - but it takes time, lots of time and lots of pain. The future is bright, getting there may not be so.

My outlook might be gloomy in the short-intermediate term, but my long, long term via is, well bright. As I've said time and time again I believe we are on the brink of technological and biological developments on par with nothing that mankind has ever witnessed. Unfortunately this will take time, perhaps decades - which we must linger through. But along that theme is this incredible breakthrough for solar power, The Atlantic profiles Lonnie Johnson:

The key to the JTEC is the second law of thermodynamics. Simply put, the law says that temperature differences tend to even out—for instance, when a hot mug of coffee disperses its heat into the cool air of a room. As the heat levels of the mug and the room come into balance, there is a transfer of energy.

Work can be extracted from that transfer. The most common way of doing this is with some form of heat engine. A steam engine, for example, converts heat into electricity by using steam to spin a turbine. Steam engines—powered predominantly by coal, but also by natural gas, nuclear materials, and other fuels—generate 90 percent of all U.S. electricity. But though they have been refined over the centuries, most are still clanking, hissing, exhaust-spewing machines that rely on moving parts, and so are relatively inefficient and prone to mechanical breakdown.

Johnson’s latest JTEC prototype, which looks like a desktop model for a next-generation moonshine still, features two fuel-cell-like stacks, or chambers, filled with hydrogen gas and connected by steel tubes with round pressure gauges. Where a steam engine uses the heat generated by burning coal to create steam pressure and move mechanical elements, the JTEC uses heat (from the sun, for instance) to expand hydrogen atoms in one stack. The expanding atoms, each made up of a proton and an electron, split apart, and the freed electrons travel through an external circuit as electric current, charging a battery or performing some other useful work. Meanwhile the positively charged protons, also known as ions, squeeze through a specially designed proton-exchange membrane (one of the JTEC elements borrowed from fuel cells) and combine with the electrons on the other side, reconstituting the hydrogen, which is compressed and pumped back into the hot stack. As long as heat is supplied, the cycle continues indefinitely.

Benoit Mandlebrot changed the way I think about everything, including Investing. His book "The (Mis)Behavior of Markets" was a clarion call to the investing community to view risk in more than just a single dimension - unfortunately it went unheeded. He is most famous for the theory of Fractal Geometry, which I won't attempt to explain but is a super important discovery. We will all miss Mandlebrot, but his ideas and influence will continue. It is my belief that his influence will continue to lead to incredible discoveries in math and science. RIP Benoit.

Every year as it begins to get cold in the northeast, oak trees drop acorns. The annual bounty helps countless squirrels, chipmunks, rabbits and other rodents endure the bitter winter months.

Let's say oak trees dropped 1.3 trillion acorns last winter and that an industrious squirrel hunted and gathered far more nuts than he needed. He sought to loan some to others, but the neighboring chipmunks and deer already had plenty. The Nuts, Acorns, and Seeds Administration, surveying the landscape, found the level of acorns unchanged at 1.3 trillion. Worried about another tough winter, it recommends that trees drop another 2 trillion acorns.

If you ever needed a reason to get rid of an incumbent politician (Republican, Democrat or Otherwise) you now have one (yet another one). I try not to get political on this blog, but what we have witnessed over the past decade (or more) is the abdication of the people's interest for Wall Street/Big Banking's interests.

The finance industry has taken over this country, led by Ben Bernanke at the Federal Reserve and the death grip they have is strangling the poor and the middle class. Nowhere is this more prevalent than in Congress where our beloved (approval rating below 20%) politicians are either in the pockets of the banking industry or just plain stupid (please understand I am not ruling out the possibility that both may apply).

HR 3808 was authored by a Republican and co-sponsored by three Democrats and guess who voted for it? Nobody knows. That's right, there is no record of WHO voted for it as it was a Voice Vote in the House and done by Unanimous Consent in the Senate (a process which I don't fully understand). There was no public debate. This was a deliberate act of Congress to evade detection of a bill that would hurt Main Street and help the Banksters by making it easier to foreclose.

Congress doesn't even have the guts to put there name on the vote and now many members are coming out against it...when it scores them political points.

No politician that I am aware of led the fight to Kill the Bill - which means they implicitly wanted it or simply didn't read the bill - neither of which is acceptable.

This is a complete betrayal of the American people and Obama did the right thing by sending it back to Congress (as if he had a choice).

I'm not going to tell you how to vote - to be perfectly honest I don't know how to vote anymore, but trusting Congress to do the right thing is not something that I have within me.

Saturday, October 02, 2010

First there were subprime loans which turned into Toxic Loans - now these Toxic Loans have spawned a whole new mess that is making national headlines - Toxic Titles. The Bloomberg article I link to above reports:

“A mortgage has to follow the proper trail every step of the way, or you have title problems,” he said.

In some cases, mortgages were conveyed using the Reston, Virginia-based Mortgage Electronic Registration System, or MERS, designed to cover transfers among system members. Promissory notes also often were endorsed as payable to the bearer to avoid the need for multiple transfers. Both practices have been challenged in court.

Copies of documents aren’t enough to establish rights, just as copies of dollar bills wouldn’t be honored by a bank, said Geoff Walsh, an attorney with the National Consumer Law Center in Boston. In cases of lost or mishandled paperwork, attorneys may file affidavits and other evidence to correct omissions and establish a claim, Walsh said.

“Wall Street was very good at packaging loans and making sure the money flowed to the right people, but not so good at keeping track of mortgage documents,” Engel said. As a result, “we have a growing number of toxic titles,” she said.

Essentially, millions of Titles (a title is what represents ownership) and current and prior Title transfers are at-risk because of sloppy paperwork and a system (MERS) that is increasingly being questioned by the courts as to whether or not it has standing.

The avalanche of disclosure this week (BofA, Chase, GMAC) that their foreclosure mills were not being run properly is but a symptom of the overall problem - Toxic Titles. If this situation is not resolved it quite literally threatens to invalidate millions of title transfers and with it, potentially trillions in value - essentially cratering the entire global economy.

Of course the powers that be would never allow this to happen, but a legal decision must be made and the courts are beginning to see the light on this issue. You can bet that the banks and Fannie/Freddie are fighting this hard and are running scared.

It’s been nearly five years since I wrote “Secrets of the Wirehouse” and I feel it is time to update it and add to it and sometimes subtract from it. You can read the original piece by clicking here. I encourage you visit my blog at http://themeridian.blogspot.com for updates on current financial events. Visit Scott’s website at www.meridianwealth.com.

Secrets of the Wirehouse

And How to Protect Your Best Interests

About the Author:

Scott Dauenhauer spent five years working for the “big three” brokerage’s and gained his knowledge first hand. He is now a Certified Financial Planner and has a Masters Degree in Financial Planning. Scott is the Owner and President of Meridian Wealth Management, a firm dedicated to protecting client interests. He believes in focusing on people not products. Though he believes there are some good people at brokerage firms, he thinks the vast majority fall extremely short of what is needed to advise a family on a subject as important as Financial Planning.

To find out more please visit his website: www.meridianwealth.com

Most Brokers Do Not Have Formal Training in Financial Planning

How much training do brokers actually have in financial planning? Major brokerage firms tout intensive training programs almost as much as the stocks they peddle. They brag about the high level of education their “consultants” receive. The truth is the only requirements are that individuals pass the Series 7, and a state insurance exam. The Series 7 is an industry test that requires memorization of facts about the markets and represents a minimum standard of knowledge.

The Series 7 does not teach an individual how to manage personal finances, let alone create a comprehensive financial plan. The Series 7 doesn’t even teach about how to properly diversify a portfolio. The insurance exam is an even bigger farce. While the Series 7 actually requires a bit of studying the state insurance exams only require minimal memorization. In California you are required to attend a 52 hour class in order to sit for your insurance exam. The class I took was excessively boring and did not teach anything about actual insurance policies or how to determine the proper amount of life insurance for an individual or family. Worst of all at the end of the 52 hour class the instructor gave you all the questions that would show up on the exam and the answers, almost word for word (I know, I took the exam and was shocked to see nearly the exact same questions).

The only thing they didn’t give you was what order the questions would be and whether the answer was a,b,c, or d. I would be willing to bet that by the time my son is 7 years old he could pass this exam. I think this is less a securities scandal and more a state governance scandal (the excuse by the state is that an easy test promotes more people in the insurance business and that the insurance companies will train the individuals……and you wonder why there is so much insurance fraud).

Anyway, once a “recruit” passes the Series 7, he/she is sent to company headquarters to go through “intensive training.” The training is definitely intensive, though not in financial planning or investment management. The programs focus solely on sales & product training and lasts anywhere from 1-4 weeks. I attended one such program and 95% of the training focused on cold-calling sales and learning proprietary product. Proprietary products are ones that are sold directly (and typically only) by the brokerage firm and typically have much higher profit margins, though mainly benefit the firm, not the person they are sold too. Brokerage firms want “salespeople,” not highly skilled financial planners.

If the firms hired highly skilled financial planners, the firm wouldn’t be able to sell proprietary products. This is because the planners would know better. When the firm hires somebody with no previous industry knowledge, or experience, they have the opportunity to fill that person’s mind with fairy tales, not fact. The firms’ way of doing business is to focus on proprietary products, high & hidden fees, cold calling, and quotas. The truth is that very few new recruits have any experience in handling another family’s wealth. You end up paying high fees for a service that puts you directly on a recruit’s learning curve. Even brokers who have been at the firm for years may not have any training in financial planning; they are stockbrokers, not trusted advisors.

As the years have gone by firms are moving slowly away from proprietary products, though not entirely. It would not be unusual to be sold a hedge fund, futures fund, or separate account, or variable annuity that is more all intents and purposes proprietary (despite a name that is different than the brokerage firms name).

Your advisor should have prior experience in financial planning and be Certified Financial Planner at a minimum, if not; you are putting your family’s wealth at risk. Please don’t let your finances be somebody else’s training ground.

Your Mutual Funds Are NOT Free

Mutual funds have grown into a huge industry. Once a small subset of money management, they have grown into a product that is now held by a large percentage of American households. There are now more mutual funds in the U.S. than stocks that trade on the NYSE. The proliferation of this medium of investing has empowered the individual investor. However, at the same time it has powered the Mutual Fund and Brokerage industry to record profits. Many of these companies are pulling the wool over your eyes. Most investors do not understand the fees accessed in their mutual fund. Even “no-load” funds have expenses. Though most of the costs are disclosed in the prospectus (good luck deciphering), some are not.

You will never see a bill for your mutual fund because the expenses are hidden. They may be hidden, but believe me, they exist. There are four major expenses involved with mutual funds (and a few minor ones). The first expense is the Expense Ratio; this compensates the manager, analysts, board of directors, and pays printing, mailing, & overhead costs and ranges from .20% to 2.0% annually. The average is about 1.5%. The next cost is what the industry refers to as a 12b-1 fee; this is basically a hidden commission. The 12b-1 fee pays to bring in new shareholders and has zero benefit to you. It varies depending on what share-class is sold to you and runs from .25% to 1.0% annually.

The last two expenses are not actually printed anywhere, you have to calculate them yourself. These expenses are spread/impact costs and transaction expenses. Every time your mutual fund buys and sells stock there are costs. The more a fund trades the more expenses YOU incur. In November of 2004 a study was released by the Zero Alpha Group (click here for the study) that stated “U.S. investors in equity mutual funds are paying $17.3 billion in hidden mutual fund trading costs that are not reported openly in the stated expense ratios of mutual funds.” The study found that on average brokerage commissions add .38% to a funds annual expense and trading costs (spreads & market impact) add another .58%. The study also found that these costs are much higher for small stock funds than large stock funds. On a conservative basis most mutual funds have additional undisclosed costs that total nearly 1% and in many circumstances higher.

Another cost you do not see is what John Bogle refers to as the “cash drag factor,” basically most mutual funds are not fully invested, they keep anywhere from 1-10% cash on hand. This hurts the performance on the upside but cushions it on the downside, since the market has gone up more often than down, the cash in the fund brings down the performance. Bogle estimates it to be about .6% on the high end. Let’s add up all the potential costs of a mutual fund, keeping in mind that brokerage firms are known for being on the high end. Passive Low End Active NormalCash Drag 0% .60%Expense Ratio .20% 1.33%12b –1 Fee’s 0% 1.00%Trading Costs .06% 1.00%

Total Costs .26% - 3.96%

The low end cost represents a person not receiving any advice; a typical fee for a professional advisor is .75% of assets annually bringing the total low end cost to around 1.00%. Not all broker sold funds have costs that are as high as shown above, however the average is somewhere between 2 - 3% annually.

Does your broker have your best interests in mind when he is charging you 2 – 4 times what a professional competent financial planner might charge? I would argue not.

Conflicts of Interest Abound – More Strings Attached Than A Marionette Puppet

Conflicts of interest exist in almost any business, the mere presence of a conflict does not automatically lead to a persons interests being wrongfully represented. However, all conflicts that are known should be disclosed in writing to the potential client before a relationship starts.

When dealing with brokerage firm conflicts of interest abound and for the most part are not disclosed. The following is a few conflicts that you should watch out for.

First, please understand to whom a public company owes their loyalty; it is to their public shareholders. The people who own stock in a company must have their interests protected. A public brokerage firm’s loyalty cannot be 100% to you.

Let’s take a further look at where other strings are attached. A broker gets paid a percentage of the revenues that he/she brings to the firm, typically 25-40%. It is not, however, that simple. Brokerage firms determine the payout percentage for each individual “product.” They control product flow by paying higher amounts to brokers for product they want sold (typically products with higher margins). While this makes sense from a business stand point and from a shareholder standpoint (why wouldn’t you want to incentivise your staff to sell the most profitable products?) it doesn’t work out so well for the end user, the client. Each firm works differently but depending on the product a firm wants to emphasize, they will pay a broker a higher percentage of the revenue to induce him to sell what the company wants him to sell. For example, if the company wants a broker to sell a Separate Account Platform product (individual money managers, more to come on this), they may tell the broker that they will receive a higher percentage of the fees they generate from that particular product and that product may generate more fees than other products.

Let me give you a real life example so that you understand.

Imagine that you had only two products to choose from to sell your client; one is a mutual fund that costs the client 2.25% annually and pays the firm 1% annually. Of the 1% paid to the firm the broker collects 35% of it or .35% annually. On a $1,000,000 account the firm generates $10,000 in revenue and pays the broker $3,500 (you the client pay $22,500). The other product is a Separate Account where you have an individual money manager. This product is sold as the latest, greatest way to have your money managed and costs 2.5% annually. However, this product pays the firm 1.5% annually and the firm will pay the broker 40% of that revenue or .60% annually. On the same $1,000,000 account the firm generates $15,000 in revenue and pays the broker $6,000 (you pay $25,000 annually). Now, in all likelihood both accounts will have similar returns over time and will probably under-perform the market. You the client in either situation are stuck in a lousy product that is expensive; however the firm has an incentive to sell one over the other, even if the other isn’t in your best interest. The separate account sale earns the firm 50% more revenue and the broker 70% more revenue – which product do you think will be presented? Each firm has their own system and they are all different, but the mechanisms are in place to manipulate the broker into selling what makes the firm and/or the broker more money.

In 2000 I wrote the following:

“A more blatant conflict is a practice that people thought was eliminated a long time ago. Some brokerage firms pay their brokers more for selling proprietary (company managed) mutual funds. To be fair, most firms have eliminated this practice, to which I applaud them, however there is still at least one major brokerage firm that sill pays brokers up to 25% more commissions to sell their company managed mutual funds over other competing funds. In addition, the more company managed funds a broker sells, the more perks they receive. Whether it is a trip, an expense account, or personal gifts, they do not receive these perks if they sell other companies funds.”

The firm I was referring to at the time was Morgan Stanley Dean Witter (now Morgan Stanley) and I don’t know if they still pay more for in house funds, but I do know that they got into a lot of trouble with the New York Attorney General and the Securities and Exchange Commission for using the allure of trips and other incentives to sell funds that they had special arrangements with. Morgan Stanley was fined $50 million, though I doubt they’ve learned their lesson. I reported on all of this going on back in 2000 before Eliot Spitzer and his gang tackled Morgan and much of the industry.

The other mutual fund scandal that was uncovered that wasn’t news to me (or anyone in the industry) was the “shelf space” arrangement. This is your basic pay to play arrangement. Certain mutual fund companies receive more access to brokers to sell their funds and more attention is paid to these funds in exchange for a basic kickback on all sales made in that fund forever. The basic system would be that a fund company could get on a brokerage firms “Preferred List” by promising to make certain “revenue-sharing” arrangements with the brokerage firm. These revenue sharing arrangements many times were simply kickbacks paid for being on the preferred list and receiving preferred access. Mutual fund companies didn’t get on a preferred list because they were the best in their class, but because they paid more than another fund company might be willing to pay. Thus the client is more apt to be recommended a fund from the preferred list even if it isn’t the best fund. Despite large fines and penalties and lots of bad press this practice continues, but at least it is now disclosed on brokerage firm websites (though I would venture to guess you’ll never hear about it from your broker). To see Morgan Stanley’s lengthy disclosure click here.

In addition to higher revenue on proprietary products, the broker many times is under tremendous pressure from management to sell you the latest mutual fund offering from that brokerage. Branch manager compensation is determined in part by the amount of proprietary products his branch sells. His interest is in getting the highest bonus possible, so he in turn puts the pressure on the brokers to “pound the phones,” and sell their “latest offering.” The brokers are enticed by management with trips, dinners, and a host of other items. It goes unspoken that if a broker does not participate in selling the new offering then things will not be easy for him/her. I know of one broker who was told, “I don’t think this firm is the right place for you,” after the broker refused to sell the new fund offering. It turned out that he was the only one to not succumb to the pressure, he eventually left that firm. I can’t begin to tell you how many voice mails & e-mails I received from management to ‘sell’ the “new” offerings, I never succumbed because it was not in my client’s best interest. Be aware that the pressure is on your broker to sell certain products or else he/she risks losing their job.

The Broker Food Chain

Guess how many entities get paid on your mutual fund purchase? You’d be astonished.

O.K., we’ve established that you pay higher costs to work with an advisor at a major brokerage firm. But who actually receives the fees that your mutual funds, and managed accounts generate? You wouldn’t believe all the entities that must be paid from your simple purchase. Most investors believe 100% of the expenses or fees go directly to the broker. Actually a very small percentage actually ends up in your broker’s pocket (which must make you also question the intelligence of your broker). In most cases the portion of the fee that the broker receives is 25-40% of the revenues your account generates for the firm. If this sounds confusing, it is, most brokers don’t even understand their own pay structures (which is exactly what the firm wants).

To help you understand, let’s take a look at a mutual fund. A typical broker sold mutual fund will have total expenses of about 2 - 4%. As I showed you in the earlier example on a mutual fund the firm might generate $10,000 on a $1,000,000 account (annually). Of the $10,000 the broker might get paid $3,500 (.35%). So where does the rest go?

It goes to pay for the fancy office, the mutual fund manager, branch manager, profits, internal departments, performance reporting, analysts, wholesalers, and a myriad of other things. Don’t get me wrong, I don’t believe profit is a dirty word; however there is a difference between profit and gouging. Your costs are high because there are so many people and departments and corporations that must receive a portion of your fees.

Let me break down the food chain for you. A person referred to as a wholesaler supports your broker, the wholesaler is the person who sells products to your broker from his/her mutual fund company. The mutual fund that employs the wholesaler also employs your fund manager and analysts to support him/her. The fund must also pay to transact business (although this cost is passed onto you, though not disclosed). The fund company and the brokerage firm must then pass along profits to it shareholders by either a higher stock price or dividends. As you can see, there are more entities getting paid on your mutual fund than you can count on one hand. I call this the Broker Food Chain. Your mutual fund purchases must make a lot of entities a profit, your broker, your brokerage firm, and the fund company, the question remains whether or not you get any profit? The broker food chain does not work in your best interest.

Insurance costs! What Your Broker Doesn’t Disclose About Their Commissions

Did you know that your stockbroker or advisor at your major brokerage firm now sells insurance? That’s right, everything from Term life to Long Term Care. Most brokers got their insurance license so they could sell you annuities (we will get to that next); they discovered however that commissions are much more lucrative in insurance than anything else. So are you to believe that your broker is now an expert in matters of insurance? Don’t believe it. Unless he/she has been through special programs like the CFP, CLU, or CHFC, they may not be qualified to offer you advice; of course that does not stop them. Of the three the CLU is the by far the strongest mark for insurance. Insurance is a complex world and if purchased incorrectly it can do a lot of harm to you and your estate.

Commissions can run anywhere from 50-120% of your policies first year premium. Surprised, don’t be, they’ve always been that high. Actually, it’s not the commission that really upsets me. If a professional does his/her job correctly and has the knowledge, training, & expertise and makes an unbiased recommendation than the commission can be justified. The problem I have is with disclosure, or rather the lack there of. Very rarely will your broker disclose what he/she is being compensated or about the potential surrender charges. The other problem I have is that many times the broker will see commissions and the appropriateness of the product as separate decisions, giving more weight to the commission than the appropriateness of the product. Many times this is done in haste because the broker simply doesn’t understand what is or isn’t appropriate. Most brokers receive sales & product training, not financial & wealth management training. In most cases your broker is a marketing representative for a large publicly traded company, not a trusted advisor like they claim.

In addition, brokers cannot go out into the marketplace and choose any provider for insurance, they must stick with pre-approved “preferred” insurance providers, well, we already know what it takes to become “preferred” at a brokerage firm, don’t expect your best insurance interest to be looked after at a brokerage firm.

Annuities, Hazardous to Your Wealth?

Annuities are an interesting product. They come in all sizes, shapes, and forms. You have probably heard of both fixed & variable annuities. Fixed annuities pay a fixed interest rate as stated in the contract for a specific time period (similar to a CD). Variable annuities performance is based on an underlying “sub-account,” basically a mutual fund. The major benefit to an annuity is the ability to defer taxes until the money is withdrawn. Another highly touted benefit is that an annuity can pay an income stream for life. Let me lay out a case for why variable annuities may be hazardous to your wealth.

It has always been said that annuities are “sold,” not bought by investors. Over 90% of all annuity sales are through brokers or life agents, a viable no-load Variable annuity industry has not emerged. Why are so many people sold annuities? The answer is simple…. high commissions and great sounding stories. There are some annuities that brokers sell that pay the broker in excess of 10% commission (though this is mainly in reference to Equity Index Annuities, another topic). This leaves you with an expensive policy and surrender charges that may last more than a decade. The expenses inside an annuity are one of the main problems. There are several expenses involved. Today most annuities do not charge you an upfront commission, the fee is charged as an annual fee (which you don’t see). This fee is deducted daily from your balance, there are five possible costs. The costs are: The policy charge, Mortality & Expense, Rider charges, underlying sub-account expenses, & transaction costs associated with those sub-accounts. Below is a range of what these cost can add up to:

Policy Charges - $30-50

M & E - 1.0 – 2.0%

Riders - .25 – 1.25%

Sub-Accounts - .25 – 1.50%

Turnover costs - .06 – 1.00%

Total Costs - 1.56 – 5.75% annually

The average cost runs about 2.5 – 4% a year. These expenses take a toll on the ability of the portfolio to match, or even beat the market. The annuity has to earn 2.5-5% before it breaks even for the year. Add the fact that gains in an annuity are taxed as ordinary income when withdrawn and the chances of your annuity beating your taxable account come close to zero. In addition, if you die with an annuity you do not receive any favorable tax consequences. You lose what the tax code refers to as the “step-up” in basis, meaning that if you die with a taxable account the entire account gets passed on to your heirs with no income or capital gains tax, not so with an annuity. Studies have shown that even low cost annuities do not produce tax benefits big enough to beat an index fund in a taxable account. In a taxable account you receive a tax break if you hold your fund or stock for one year or more, not so with an annuity (plus dividends are now only taxed at 15% on the federal level, though this is set to expire). Lastly, you have very limited choice of investments in the annuities and if you want to take your money out before age 59 ½ you are out of luck, you would owe a 10% tax penalty.

You may ask “what about the guaranteed death benefit?” It is basically worthless in most circumstance. Annuities are long-term investments, they are not meant for periods of less than 10 years. If you end up being one of those poor unfortunate souls that bought at the top of the stock market and still have less money than you started with 10 years ago (extremely unlikely, but it happens, though usually do to idiot broker advice) then your loss exposure is likely minimal. An amount that will be less than what you probably paid for the insurance over that period. In any event, the death benefit is not a logical reason to purchase an annuity. The death benefit in an annuity is also rather inconvenient in that in order to collect you must DIE. I don’t know about you, but that is one “benefit” that doesn’t benefit me. Now, of course, if you have loved ones that you want to provide for a death benefit may offer you some peace of mind. Keep in mind what you pay for that peace of mind and the likelihood of it ever being collected on. If you are insurable purchase insurance, if you are not, perhaps a variable annuity with a death benefit makes sense (though I still highly doubt it). If in the extremely rare circumstance that a death benefit makes sense in a variable annuity my choice would be to purchase a variable annuity from the Vanguard Group, they offer a low cost account with a death benefit.

Let’s recap the problems with Variable Annuities. High expense, high marketing costs, tax penalties if under 59 ½, loss of capital gains status, loss of step-up, limited choice of investment vehicles, & worthless death benefits. So why do people continue to be sold these products? High commissions and high profitability to the companies involved. Profit is the bottom line, not your interests. Variable annuities have become such a problem that the SEC (regulator) has issued a booklet available online through its website www.sec.gov. that lists the pros and cons of annuities. In addition they are in the process of taking legal action against several major companies and brokers over selling tax-deferred annuities to people whom already have tax deferred accounts.

Living Benefits

Variable Annuity providers knew that the death benefit just wasn’t enough to keep the sale of variable annuities going, so they came up with a whole new generation of benefits for variable annuity products dubbed Living Benefits. The four major living benefits that are offered are as follows:

Guaranteed Minimum Withdrawal Benefit (GMWB)

Guaranteed Minimum Withdrawal Benefit For Life

Guaranteed Minimum Income Benefit

Guaranteed Minimum Accumulation Benefit

These living benefits are sold with some really great stories and too good to be true promises. I can’t even begin to get into the inner workings of each of these so called benefits because it would bore you and take up a lot of space. Suffice it to say that these living benefits are expensive (despite what your broker will tell you) and are not all they are cracked up to be. If you are being told that you will be guaranteed 7% on your money, beware and read the small print. If you are being told that regardless of stock market performance you can withdrawal 7% of your account annually, beware. The stories that are used to sell these products are wonderful, they sound like an investors dream, but reality is much different. These products are costly and in most cases fixed against the possibility of a claim being made. Always read the fine print and hire a professional who has nothing to gain to review any variable annuities recommended to you.

The “Bonus” Annuity Scam…

If you are an annuity holder, chances are you have been approached by an insurance agent trying to sell you an annuity that pays you an ‘upfront’ bonus. Whatever you do, do not succumb to the sales pitch for the new “bonus” annuities. This is a new and highly aggressive tactic of the industry, to keep investors “imprisoned” in a high cost product, and generate new and even larger commissions for the sales force. Annuity holders with a few years left in their surrender charge period are approached with the following “typical” story:

“I understand that you are unhappy with your current variable annuity because of poor performance, lack of investment choices & a fading death benefit. I also understand that you have a surrender charge left. We are going to “help” by giving you an up-front “bonus” of 3-6% to cover the surrender charge. It will not cost you anything to switch.”

Unfortunately, the only “bonus” is to the salesperson. The new sale starts the surrender period all over again and the salesperson gets another commission. It is a great deal for the agents, they get two commissions from you.

To pay for the bonus and the commission and any extras, the insurance company raises the expenses on your investments. Since these expenses are buried in the prospectus and hidden from you on your statements, you never know that you are being taken advantage of. When all is said and done, everybody is making money except you! I have actually been in meetings and heard brokers laugh at how they duped another person into a “bonus” annuity. They refer to the extra commission internally as the “Yield to Broker.” It appears that the SEC is coming down hard on this practice. On June 5th, 2000, they issued an “investor alert” and placed a brochure on its website to help investors understand the benefits, costs, and risks of variable annuities, which combine features of mutual funds and insurance.

Insurance companies have been hit with rounds of lawsuits stemming from churning and suitability. It seems that the real “bonus” will be new business for trial lawyers!!!

Equity Indexed Annuities

These annuities are sold mostly by independent insurance agents, but I believe you will see more brokerage firms selling them in the future (along with banks). Equity Index Annuities or EIA’s have a great story to tell, typically it goes like this:

“Would you like an investment that pays gains based on the stock market, yet helps protect your principal when the market declines?”

Wow, market goes up I make money, market goes down I don’t lose money, where do I sign up? This latest derivative of the fixed annuity has grown in popularity over the past few years due to what appeared to most people to be a lackluster or falling market (not true), fear, and high commissions.

First, let’s be clear about what an Equity Indexed Annuity is, it is a fixed annuity. A fixed annuity that credits you interest that is based on some portion of an index’s return, typically the S & P 500. Your money is not invested in the stock market at any time and your returns will not be reflective of the stock market. Over time your returns will be similar to that of a fixed annuity, possibly a little better. However, you will be subjected to long surrender periods, excessive surrender charges (due to excessive commissions) and outright lies about the possible performance. Even though your returns are linked to a market index, the insurance company controls how the link is determined and has the ability to manipulate it so that the interest paid out is nowhere near what the market returns. In the real world there is no free lunch, you can’t experience the returns of the market without experiencing the risk. The insurance companies utilize many methods to ensure that your credited interest rates are not too high over the long term and in most cases the products are structured to benefits the companies and agents selling the products. It would be too lengthy to go into the inner workings of the index annuity here, but if you really want to talk about it give me a call, especially if someone is trying to pitch you one of these lame excuses for a financial product. The commissions and incentives linked to index annuity sales are a scandal much bigger than the Morgan Stanley settlement I spoke of earlier in this piece. While Morgan Stanley was fined $50 million for offering incentives to sell certain funds, insurance marketing companies do the same thing every day and get away with it. Trips to Monte Carlo, the Caribbean, and Mexico are everyday fare in the world of index annuity sales. What is motivating the sale of the index annuity, your best interest or a commission and a trip to the Caribbean?

Bank Insured Money Market Accounts

If you are a brokerage firm customer you may have noticed that over the past couple years the name of your money market fund has changed, or perhaps you didn’t notice. Most people haven’t noticed and that is what the brokerage world wants. As if the brokerage firms weren’t extracting enough income from you they devised a new way to make money on you, bank insured money market accounts. It used to be that you had a normal money market account that invested in short term investments and you received a pretty good return, though the fees were usually higher than say a Vanguard money fund. However, the brokerage firms decided that they using your money to support other entities borrowing habits didn’t make them much money, thus they devised a rather ingenious plan to use your money to support their one borrowing and lending habits. Basically your regular money market fund was replaced by a lower yielding money market fund that is touted to you as “bank insured.” This sounds good to you, insured money sounds better than uninsured money, but in reality the brokerage firms are now making money on your money twice. They make money by charging you an asset management fee to run the money market fund and secondly by directing your money into their own bank. Each brokerage firm sets up their own bank and the money that is deposited to the money market funds is lent to this bank as bank deposits that can be lent out to consumers and business, thus allowing the brokerage firm to earn another spread on your money. Perhaps this would be ok if it was truly disclosed to you and you could be guaranteed not to earn anything lower than a good institutional money market fund, but in reality your yield is much lower than say the yield at Vanguard, or even other money market funds offered by your brokerage firm. You get a new bank insured money market fund, a lower yield and the brokerage firm gets a new revenue source……does this sound like it is in your best interest?

Your Best Interest and the Merrill Lynch Rule – Brokerage Firms Fight Being Labeled a Fiduciary

I’ve spoke a lot about the conflicts of interests that exist at most brokerage firms and these conflicts stem from the fact that there is no requirement at a brokerage firm that your best interest be put first. This means your broker is not required to act as your fiduciary. A Fiduciary is someone who is required to place their client’s interest first, even above their own. Interestingly enough the brokerage firms have been fighting for years to avoid having to become fiduciaries despite the fact that they hold themselves out to be financial planners and advisors (who in most cases are required to be fiduciaries). The fight against being a fiduciary played itself out in what is now known as the Merrill Lynch rule. The Merrill Lynch Rule allows brokerage firms to offer advice for a fee without having to be fiduciaries. It is troubling how far the brokerage firms will go to ensure that they are not called fiduciaries. They are willing to fight because they know that they CANNOT honestly act as a fiduciary and continue to do business as they do now. Ask your broker if he/she is acting as your fiduciary and then get it in writing. Chances are they won’t put it in writing and they won’t put your best interest first.

John Talbott (a guy who called the housing bubble (wrote two books on it) and the financial crisis is a little upset with the New York Times article this morning that essentially gives TARP a pass. What follows is Talbott's tally of bailouts:

Federal Reserve's increased printing of money to fund purchase of mortgage securities in market and bad assets from banks (which directly leads to an equal amount of inflation, a hidden tax on consumers and savers) = $2 trillion.

Eventual FDIC losses = $500 billion.

Credit union guarantees = $50 billion.

Present value cost of lost interest income to US retirees and other savers due to government's zero interest rate policy = $2 trillion.

Present value cost of additional high unemployment and lost wages caused by government's focusing on bank and Wall Street profitability first, rather than on job creation = $5 trillion.

Total loss in housing values due to inappropriate response to overbuilding and high foreclosure problem = $4 trillion (a fraction of the total housing value loss of10 trillion, much of which was necessary to return to non-bubble levels).

Cost of future bad loans created since 2008 by Fannnie, Freddie and FHA by continuing to lend aggressively into declining real estate markets = $300 billion.

Wasted stimulus money (Where exactly did this money go and what do we have to show for it?) = $300 billion.

Total estimated cost of government bailout = $14.85 trillion.

This is more than an entire year's economic output for the entire country. It is as if we Americans worked an entire year for free to pay for our government's inappropriate response to this crisis.

If you've never watched,listened or read Jim Grant you are missing out. He is a great satirist, but more importantly a great contrarian. This clip from Bloomberg has more important information in it than you will find on CNBC and Fox Business in a month.

About a year ago a good friend of mine and I were having lunch up at UCLA. We got onto the topic of alternative energy and I expressed my belief that within the next twenty years today's solar panels would resemble a Commodore 64 computer - in other words, cutting edge at the time but essentially a non-starter.

This new discovery by researchers at the University of Wyoming and Colorado State may be the next evolution in creating the next generation of solar panels. In my opinion there are two endless resources that if we could harness and use for our energy consumption we could quite literally change the world (this is hardly a unique thought) - those resources are of course the Sun and our Oceans. I believe we are now laying the groundwork for an explosion of new energy sources that will set the earth on a prosperity boom unlike anything ever witnessed to date.

Of course we have some real short term issues that could very well drag us into multiple depressions around the globe first. While I am quite gloomy about what we have wrought for our future generations fiscally, I am quite ecstatic about what technology, bio-technology will unleash in the future.

If you'd like to read more about this new technology (which is still in its infancy), click the headline above.